IFRS 16, Leases

1. Introduction and context setting

International Financial Reporting Standard (IFRS®) 16, Leases was issued in January
2016 and has been effective for periods beginning on or after 1 January 2019. Early
adoption was also permitted for entities that applied IFRS 15, Revenue from
Contracts with Customers at or before the date of initial application of IFRS 16. The
purpose of this article is to summarise some of the key issues related to IFRS 16
from the perspective of the lessee and how these impact on financial reporting.
IFRS 16 replaced International Accounting Standard (IAS®) 17. The approach of IAS
17 was to distinguish between two types of lease. Leases that transfer substantially
all the risks and rewards of ownership of an asset were classified as finance leases.
All other leases were classified as operating leases. The lease classification set out in
IAS 17 was subjective and there was a clear incentive for the preparers of lessee’s
financial statements to ‘argue’ that leases should be classified as operating leases
rather than finance leases in order to enable leased assets and liabilities to be left off
the statement of financial position.
It was for this reason that IFRS 16 was introduced. Although the concept of
operating leases and finance leases still exists from the perspective of the lessor,
they do not relate to the accounting of the lessee and lessor accounting is beyond
the scope of this article.
2. IFRS 16 – assets
At the inception of a contract, an entity must assess whether the contract is, or
contains, a lease. This will be the case if the contract conveys the right to control the
use of an identified asset for a period of time in exchange for consideration.
To assess whether a contract conveys the right to control the use of an identified
asset for a period of time, the lessee must have both of the following:
 the right to obtain substantially all of the economic benefits from the use of
the identified asset, and
 the right to direct the use of the identified asset.
2.1 An ‘identified asset’
One essential feature of a lease is that the underlying asset (ie the asset that is the
subject of the lease) is ‘identified’. This normally takes place through the asset being
specified in a contract, or part of a contract. For the asset to be identified, the
supplier of the asset must not have the right to substitute the asset for an alternative
asset throughout its period of use. The fact that the supplier of the asset has the
right or the obligation to substitute the asset when a repair is necessary does not
preclude the asset from being an ‘identified asset’.
Example – identified assets
Under a contract between a local government authority (L) and a private sector
provider (P), P provides L with 20 trucks to be used for refuse collection on behalf of
L for a six-year period. The trucks, which are owned by P, are specified in the
contract. L determines how they are used in the refuse collection process. When the
trucks are not in use, they are kept at L’s premises. L can use the trucks for another
purpose if it so chooses. If a particular truck needs to be serviced or repaired, P is
required to substitute a truck of the same type. Otherwise, and other than on default
by L, P cannot retrieve the trucks during the six-year period.
Conclusion: The contract is a lease. L has the right to use the 20 trucks for six years
which are identified and explicitly specified in the contract. Once delivered to L, the
trucks can be substituted only when they need to be serviced or repaired.
2.2 The right to direct the use of the asset
IFRS 16 states that a customer has the right to direct the use of an identified asset if
either:
 The customer has the right to direct how and for what purpose the asset is
used throughout its period of use; or
 The relevant decisions about use are pre-determined and the customer has
the right to operate the asset throughout the period of use without the
supplier having the right to change these operating instructions, or the
customer designed the asset in a way that predetermines how and for what
purpose the asset will be used.
Example – the right to direct the use of an asset
A customer (C) enters into a contract with a road haulier (H) for the transportation
of goods from London to Edinburgh on a specified truck. The truck is explicitly
specified in the contract and H does not have substitution rights. The goods will
occupy substantially all of the capacity of the truck. The contract specifies the goods
to be transported on the truck and the dates of pickup and delivery.
H operates and maintains the truck and is responsible for the safe delivery of the
goods. C is prohibited from hiring another haulier to transport the goods or
operating the truck itself.
Conclusion: This contract does not contain a lease.
There is an identified asset. The truck is explicitly specified in the contract and H
does not have the right to substitute that specified truck.
C does have the right to obtain substantially all of the economic benefits from use of
the truck over the contract period. Its goods will occupy substantially all of the
capacity of the truck, thereby preventing other parties from obtaining economic
benefits from use of the truck.
However, C does not have the right to control the use of the truck because C does
not have the right to direct its use. C does not have the right to direct how and for
what purpose the truck is used. How and for what purpose the truck will be used (ie
the transportation of specified goods from London to Edinburgh within a specified
timeframe) is predetermined in the contract. Although it is possible for rights to be
predetermined in a contract, in this contract C does not have any decision-making
rights relating to the use of the asset.
Therefore, C has the same rights regarding the use of the truck as if it were one of
many customers transporting goods using the truck. In other words, C is simply
paying for haulage services rather than leasing a truck.
3. Accounting for leases
With very few exceptions (see section 3.4 for further details), lessees recognise a
‘right-of-use-asset’ (ie an asset in the statement of financial position representing
the right to use an underlying asset) and an associated liability at the
commencement date of the lease (ie the date that the lessor makes the underlying
asset available for use by the lessee).
IFRS 16 requires that the lease liability should initially be measured at the present
value of the lease payments that are not paid at the commencement date. The
discount rate used to determine present value should be the rate of interest implicit
in the lease.
3.1 Recording the asset
The right-of-use-asset would include the following amounts, where relevant:
 the amount of the initial measurement of the lease liability (as described
above)
 any payments made to the lessor at, or before, the commencement date of
the lease, less any lease incentives received
 any initial direct costs incurred by the lessee
 an estimate of any costs to be incurred by the lessee in dismantling and
removing the underlying asset, or restoring the site on which it is located
(unless the costs are incurred to produce inventories, in which case they
would be accounted for in accordance with IAS 2 Inventories). Costs of this
nature are recognised only when an entity incurs an obligation for them. IAS
37, Provisions, Contingent Liabilities and Contingent Assets would be applied
to ascertain if an obligation existed.
3.2 Depreciation
The right-of-use-asset is subsequently depreciated. Depreciation is over the shorter
of the useful life of the asset and the lease term, unless the title to the asset transfers
at the end of the lease term, in which case depreciation is over the useful life.
3.3 Lease liability
The lease liability is effectively treated as a financial liability which is measured at
amortised cost, using the rate of interest implicit in the lease as the effective interest
rate.
Example – accounting for leases
A lessee enters into a 20-year lease of one floor of a building, with an option to
extend for a further five years. Lease payments are $80,000 per year during the
initial term and $100,000 per year during the optional period, all payable at the end
of each year. To obtain the lease, the lessee incurred initial direct costs at the
commencement date of $25,000.
At the commencement date, the lessee concluded that it is not reasonably certain to
exercise the option to extend the lease and, therefore, determined that the lease
term is 20 years. The interest rate implicit in the lease is 6% per annum which is
equivalent to a 20-year cumulative discount factor of 11.470. The present value of
the 20 years of lease payments is $917,600 ($80,000 x 11.470).
The carrying amount of the right-of-use-asset at the commencement date is
$942,600 ($917,600 + $25,000 initial direct costs) and consequently the annual
depreciation charge will be $47,130 ($942,600 x 1/20).
The lease liability will be measured using amortised cost principles. In order to help
us with the example in the following section, we will measure the lease liability up
to and including the end of year two. This is done in the following table:
At the end of year one, the carrying amount of the right-of-use-asset will be
$895,470 ($942,600 less $47,130 depreciation).
The interest cost of $55,056 will be taken to the statement of profit or loss as a
finance cost.
The total lease liability at the end of year one will be $892,656. As the lease is being
paid off over 20 years, some of this liability will be paid off within a year and should
therefore be classed as a current liability.
To find this figure, we look at the remaining balance following the payment in year
two. Here, we can see that the remaining balance is $866,215. This will represent
the non-current liability, being the amount of the $892,656 which will still be
outstanding in 12 months’ time. The current liability element is therefore $26,441.
This represents the $80,000 paid in year two less year two’s finance costs of
$53,559 (or $892,656 – $866,215).
Therefore, where payments are being made in arrears as is the case here, the non-
current liability is the balance carried forward at the end of year two. The current
liability is the difference between the total liability at the end of year one and the
non-current liability (ie the total liability remaining at the end of year two).
However, this is not the case where payments are made in advance.
The following table could be used to calculate the relevant figures if payments were
to be made in advance instead of in arrears. You should note the different placement
of the payment column and the inclusion of a ‘subtotal’ column. For simplicity, we
have used the same effective interest rate of 6%:

As payments are made in advance, this is equivalent to a 19-year cumulative

discount factor of 11.158 since the first payment of $80,000 is incurred on the
commencement of the lease. Therefore, the first payment is not discounted and the
subtotal in year one of $892,640 ($80,000 x 11.158) would be the lease liability that
should initially be recognised on commencement of the lease.
The initial lease payment of $80,000 would actually be included as part of the cost of
the right-of-use asset rather than the lease liability. This is because, as noted earlier
in section 3.1, the cost of the right-of-use asset should include the initial
measurement of the lease liability plus any lease payments made at or before the
commencement date.
Where payments are made in advance, the non-current liability would be the
subtotal for year two ($866,198) and not the total liability carried forward at the
end of year two as is the case with payments in arrears. This is because, with
payments in advance, the balance carried forward at the end of year two includes
the finance cost for year two.
In the case of both payments in arrears and payments in advance, the non-current
liability is represented by the balance outstanding immediately after the payment in
year two. In both cases, the current liability is the difference between the total
liability at the end of year one (ie the end of the current year) and the non-current
liability. This means that for payments in advance, the current liability would simply
be $80,000 in this example.
3.4 A simplified approach for short-term or low-value leases
A short-term lease is a lease that, at the commencement date, has a term of 12
months or less. A lease that contains a purchase option cannot be a short-term lease.
Lessees can elect to treat short-term leases by recognising the lease rentals as an
expense over the lease term rather than recognising a right-of-use-asset and a lease
liability. The election needs to be made for relevant leased assets on a ‘class-by-
class’ basis. A similar election – on a lease-by-lease basis – can be made in respect of
leases for which the underlying asset is of low value (ie ‘low-value leases’).
The assessment of whether an underlying asset is of low value is performed on an
absolute basis. Leases of low-value assets qualify for the simplified accounting
treatment explained above regardless of whether those leases are material to the
lessee. The assessment is not affected by the size, nature or circumstances of the
lessee. Accordingly, different lessees are expected to reach the same conclusions
about whether a particular underlying asset is of low value.
An underlying asset can be of low value only if:
(a) The lessee can benefit from use of the underlying asset on its own or together
with other resources that are readily available to the lessee; and
(b) The underlying asset is not highly dependent on, or highly interrelated with,
other assets.
A lease of an underlying asset does not qualify as a lease of a low-value asset if the
nature of the asset is such that, when new, the asset is typically not of low value. For
example, leases of cars would not qualify as leases of low-value assets because a
new car would typically not be of low value.
Examples of low-value underlying assets can include tablets and personal
computers, small items of office furniture and telephones.
4. Sale and leaseback transactions
4.1 Introduction
The treatment of sale and leaseback transactions depends on whether or not the
‘sale’ constitutes the satisfaction of a relevant performance obligation under IFRS
15. The relevant performance obligation would be the effective ‘transfer’ of the asset
to the lessor by the previous owner (now the lessee).
4.2 Transaction constituting a sale
If the transaction does constitute a sale under IFRS 15 then the treatment is as
follows:
 the seller-lessee shall measure the right-of use asset arising from the
leaseback at the proportion of the previous carrying amount of the asset that
relates to the right of use retained
 the seller-lessee shall recognise only the amount of any gain or loss that
relates to the rights transferred to the buyer-lessor
 the buyer-lessor shall account for the purchase of the asset applying
applicable Standards, and for the lease applying the lessor accounting
requirements in IFRS 16.
If the fair value of the consideration for the sale of an asset does not equal the fair
value of the asset, or if the payments for the lease are not at market rates, an entity
shall make the following adjustments to measure the sale proceeds at fair value:
 Any below-market terms shall be accounted for as a prepayment of lease
payments, and
 Any above-market terms shall be accounted for as additional financing
provided by the buyer-lessor to the seller-lessee.
Example – sale and leaseback
Entity X sells a building to entity Y for cash of $4.5 million, which is the fair value of
the building. Immediately before the transaction, the carrying amount of the
building in the financial statements of entity X was $3.5 million. At the same time, X
enters into a contract with Y for the right to use the building for 20 years, with
annual payments of $200,000 payable at the end of each year. The terms and
conditions of the transaction are such that the transfer of the building by X satisfies
the requirements for determining when a performance obligation is satisfied in IFRS
15. Accordingly, X and Y account for the transaction as a sale and leaseback.
The annual interest rate implicit in the lease is 5%. The cumulative discount factor
for 5% for 20 years is 12.462. The present value of the annual payments (20
payments of $200,000, discounted at 5%) amounts to $2,492,400.
X would recognise a right-of-use-asset arising from the leaseback of the building.
This would be measured as the proportion of the previous carrying amount that
relates to the right of use retained by X. On this basis, the right of use asset would be
$1,938,533 ($3,500,000 carrying amount of the building ÷ $4,500,000 fair value of
the building x $2,492,400 present value of the expected lease payments). Similarly,
this could be calculated as the proportion of the equivalent asset retained by X.
The total gain on the sale of the building is $1,000,000 ($4,500,000 fair value –
$3,500,000 carrying amount). However, X can only recognise $446,133 as this is the
amount of the gain that relates to the rights transferred to Y ($1,000,000 total gain ÷
$4,500,000 fair value x ($4,500,000 fair value – $2,492,400 present value of annual
payments)).
4.3 – Transaction not constituting a ‘sale’
If the transfer of an asset by the seller-lessee does not satisfy the requirements of
IFRS 15, although a legal transfer of the asset has taken place, the seller does not
‘transfer’ the asset for accounting purposes. Instead, the seller continues to
recognise it in the statement of financial position without adjustment. The ‘sales
proceeds’ are recognised as a financial liability and accounted for by applying IFRS
9, Financial Instruments. In the same circumstances, the buyer recognises a financial
asset equal to the ‘sales proceeds’.
5. Summary
Under IFRS 16, most lease contracts result in the recognition of right-of-use-assets
and lease liabilities in the statement of financial position. Therefore, leasing assets
under IFRS 16 without using the exemptions related to short-term or low value
leases has significant impacts on key accounting ratios of lessees – they will reduce
return on capital employed and increase gearing. Similarly, when compared to the
exemptions for short-term and low-value leases, entering into a lease where these
exemptions do not apply will reduce measures of profit. This is because, in the early
years of a lease, the combination of depreciation of the right-of-use-asset and the
finance charge associated with the lease liability will exceed the lease expense
applicable with short-term and low-value leases (normally charged on a straight-
line basis).